Volatility and Binary Options

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Binary Options

What are binary options

A binary option is a type of option with a fixed payout in which you predict the outcome from two possible results. If your prediction is correct, you receive the agreed payout. If not, you lose your initial stake, and nothing more. It’s called ‘binary’ because there can be only two outcomes – win or lose.

Advantages of binary options trading

Aside from the simplicity of its ‘yes or no’ proposition, binary options trading is also very flexible. It gives you the ability to trade:

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Trade on underlying markets that include Forex, indices, commodities, and more.

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Predict market movement using up/down, touch/no touch, and in/out trade types.

  • All durations

Take a short-term or long-term view with trade durations from 10 seconds to 365 days.

  • All payouts

Earn payouts up to USD 50,000. Losses are limited to your initial stake and nothing more.

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Volatility In A Hand Basket

Volatility Indicators For Binary Options

Volatility is a great method of analysis for binary traders to get acquainted with. While most average traders will shy away from volatility if you learn to understand it and how to apply it to your trading it can lead to explosive profits. In previous postings I have gone over some reasons why volatility is your friend and how to apply volatility to your trading so today I will go over some commonly used indicators. By no means is this a be-all end-all guide to volatility indicators but it is a useful guide into the different methods of measuring volatility and how that information can be displayed on your charts. To quickly touch base, volatility is the measure of movement in an asset and can be current, relative, historical, implied and used to create bands, rays, oscillators and moving averages.

Historical Volatility – Historical volatility is a measure of how volatile an asset has been in the past. It is a measure of the standard deviation of prices over a set period and is used to predict how volatile an asset will be in the future. It is natural to assume that a higher volatility asset will have a higher standard deviation and therefore a higher historical volatility, which is true. This is a useful tool because it can help traders determine the amount of movement that is likely to occur. The caveat is that the movement implied by the indicator could be in either direction, not just the direction you want, so it is vital that you do not use this indicator by itself.

Implied Volatility – Implied volatility is a projection of how volatile an asset can be expected to be. This may sound a bit like historical volatility but there are differences. It is based on the prices of standard options relative to the price of the underlying asset. I know, as binary traders this doesn’t matter to us but it does, let me assure you. Implied volatility can be used to measure extremes of market sentiment; when implied volatility is extremely high, or extremely low, it can indicate times when the market is about to change direction. The higher the implied volatility, the larger the expected movement can be and vice/versa. Implied and historical volatility can both be displayed as an oscillator or directly on the charts.

Relative Volatility – Relative volatility is an oscillator style indicator that measure market movements relative to past price history. It was invented by Donald Dorsey and gives an indication of the direction of volatility. This is important because volatility on its own is merely a measure of movement, not direction. The indicator moves between 0 and 100 on a calculation based on 10 days/bars of data and then smoothed by a 14 period moving average. These parameters can be adjusted to suit your needs but I always like to use standard settings on my indicators. This indicator is a marvelous measure of market strength and should be used as confirmation of other signals such as moving averages or MACD. When the indicator rises above 50 it indicates positive strength, when it falls below 50 it indicates negative strength.

Chaikin Volatility – Chaikin Volatility is another oscillator style volatility indicator. It is a source for debate as it measure volatility as the movement between the open and the close and does not include gaps as other indicators do. Another difference in this indicator is in how it is derived. This one is not based on standard deviation but on percentage movements relative to a moving average of high and low prices over N days. The standard set up is for a 10 day period, smoothed by a 10 day moving average. It is often used to indicate tops and bottoms of trends as sharp increases in the indicator often precede market reversals. The indicator is best used as a confirmation of other indicators as with most tools in this group. It works well with Fibonacci Retracements as well as other trend and support/resistance tools.

Bollinger Bands ™ – Bollinger Bands ™ are fantastic method of utilizing volatility for binary options. This indicator uses a standard deviation of prices to create a moving average and a pair of signal lines that create a sort of volatility envelope around prices. As volatility increases in the asset the bands will widen, as it decreases they will narrow. Price action will move from one extreme to the other and provide signals along the ways. The indicator can be used to indicate continuation, reversal and for signals like crossovers and continuations. It is by far the preeminent volatility indicator of this group and a top recommended tool for binary traders. It can be used by itself or in conjunction with other indicators and can be applied to charts ranging from 1 minute to 1 day to 1 week to 1 month.

Volatility Indicators And Binary Options – The Guide

Volatility indicators and binary options are a great combination. They can create simple but highly profitable trading strategies. What is even better: two of the strategies which we will teach you can win you a trade without requiring you to predict the direction in which the market will move – trading could not be simpler.

In this article, you will learn:

  • What Are Volatility Indicators?
  • Why Use Volatility Indicators For Options?
  • Three Strategies For Volatility

With this information, you will be able to create your own profitable binary options strategy based on volatility indicators.

What Are Volatility Indicators?

Volatility indicators are technical indicators. That means they aggregate the data of past market movements, apply a formula, and display the result in a way that allows traders to quickly and simply understand what is going and what will happen next.

Technical indicators focus solely on price action. That means they ignore all fundamental information about the underlying asset, for examples the earning of a company or the economic prospect of a country. Instead, they analyze what has happened to an assets price in the past and create predictions based on this analysis.

Volatility indicators are a special form of technical indicators. They measure how far an asset strays from its mean directional value. This might sound complicated but it simple:

  • When an asset has a high volatility, it strays far from its average direction. An earthquake, for example, has a high volatility. Things were quiet for a long time, and now there is a strong movement that often changes direction. Assets with a high volatility suffer constant earthquakes. They often trade far away from their moving averages and routinely change direction.
  • When an asset has a low volatility, it has a strong sense of direction. The earth’s movement around the sun has a low volatility, for example. Assets with a low volatility share this strong sense of direction. Their direction can change over time, but they trade much closer to their moving averages that assets with a higher volatility and change direction much less.

Volatility indicators measure an asset’s volatility and display it in a way that makes it easy for you to predict what will happen next.

Examples Of Volatility Indicators

There are two main types of volatility indicators:

  1. Oscillators calculate a value and draw it into a separate chart, usually below the price chart. The current value and its relation to past values allow for interpretations of what traders are currently thinking and for predictions about what will happen next.
  2. Channels use the volatility to calculate a price channel and draw this channel directly into your main chart. The channel surrounds the current market price and predicts the range in which the market is likely to remain. Channels predict that market that has moved too far from an average are likely to make traders nervous, which will lead them to invest in the opposite direction and bring the market back to its average.

Let’s look at examples of both types:

Example 1: The Average True Range (ATR)

There are many volatility oscillators. The most accurate of them is the Average True Range (ATR). The ATR wants to find out how far an average period of an asset has moved in the past, but it uses a more accurate method of calculation than other indicators.

Other indicators use a fixed formula, for example always subtracting the current period’s high from its low. While this method is accurate, it ignores gaps. Sometimes, the market jumps from one price to another, which creates a gap in the market. Momentum indicators that ignore these gaps paint a distorted picture. The ATR’s main advantage is that it recognizes gaps and factors them into its calculation.

For a detailed explanation of the ATR, please read our article on the ATR. For this article, the important point is that the ATR calculates each period’s true range and then creates an exponentially smoothed moving average.

The result tells you the average true range of the last periods. For example, when the ATR has a value of 0.1, you know that an average period has £0.1 in the past. You can use this value to predict the range of future market movements.

You can also interpret the value in relation to previous values.

  • If the value has dropped from £0.2 to £0.1, you know that market is losing energy.
  • If the value has risen from £0.05, you know that the market is picking up steam.

Both trends are likely to continue. They create different situations that require different trading strategies, and the ATR helps you to identify which one is right for now.

Example 2: Bollinger Bands

Bollinger Bands create a price channel around the current market price. The market price’s relation to this price channel helps you predict what will happen next.

The Bollinger Bands’ price channel consists of three lines:

  • A moving average as the middle line. The typical value for this moving average is 20 periods. Theoretically, you can use any value you want, but this value has worked best for most traders. When the market is above the middle line, it works as a support line. When the market is below the middle line, it works as a resistance.
  • An upper and a lower line based on the standard deviations. Most traders use a value of two times the standard deviation for both lines. The upper line works as a resistance, the lower line as a support.

Bollinger Bands predict that the market will stay within the upper and the lower line. The middle line works a barrier that can be a support or a resistance. This means, when the market approaches a line, it is likely to turn around. While it can eventually break the middle line, it is highly unlikely to move past the outer lines.

For traders, Bollinger Bands allow simple predictions. They provide clear indications for a movement’s possible reach and plenty of resistance and support lines that allow for easy trades.

Why Use Volatility Indicators For Options?

Binary options traders can profit from volatility indicators more than traders of conventional assets. There are two main reasons for this statement:

Some Trades Win On Volatility Alone

Traders of conventional assets are unable to win a trade on volatility alone. Stock traders, for example, can use volatility indicators as one factor in the decision-making process, but volatility indicators say little about whether an asset’s price will rise or fall – they only predict that it will go somewhere.

This is unfortunate. Volatility indicators are one of the few types of indicators that can provide clear predictions, but they are insufficient to win stock traders a trade, robbing them of the possibility to create a simple, mathematical strategy.

For binary options traders, however, knowing that the market will go somewhere can be enough to win a trade.

Volatility And Boundary Options

Binary options offer a tool called boundary options. A boundary option defines two target prices in the equal distance of the current market price, one above the current market price and one below it. When the market reaches one of these target prices, you immediately win your binary option.

Boundary options are ideal for momentum indicators. For example, assume that an asset is trading at £100 and that your broker is offering you a boundary option with an expiry of one hour. The target prices are at £100.20 and £99.80.

To predict whether the market can reach either target price, all you have to do is apply the ATR and set the period of your chart to one hour. Now two things can happen:

  1. The ATR reads 0.2 or more. In this case, you know that an average period has moved £0.20 or more in the past. Since this would be enough for the market to reach the target price, you know that there is a good chance that you would win the boundary option
  2. The ATR reads less than 0.2. In this case, you know that an average period would have been insufficient to win your boundary option. If you have reason to believe that the next period will be stronger than average, you might invest anyway, but this trade would be a bad idea based on the momentum indicator.

Depending on your tolerance for risk, you can adapt your strategy. You could wait to invest until the ATR reads twice or three times as much as the distance to both target prices. The longer you wait, the less trading opportunities you find. But you will win a higher percentage of your trades, which can be worth the tradeoff for risk-averse traders.

Traders Can Triple Profits With Volatility Indicators

There are many types of binary options. Often, there are two or more similar types that only differ in the strength of the required movement. The type that requires a stronger movement compensates traders by providing a higher payout.

For example, there are high/low options and ladder options.

  • High/low options allow you to predict whether the market will trade higher or lower than the current market price when the option expires. If you are right, you get a payout of around 70 to 85 percent.
  • Boundary options allow you to predict whether the market will trade higher or lower than a target price. Predicting that the market will trade higher than a target price that is far above the current market price, can get you a payout of up to 1,500 percent. Predicting that the market will trade above a target price that is below the current market price will get you a lower payout, maybe only 20 percent.

Larger Movement Means Higher Payout Potential

Simply put, predicting a stronger movement will get you a higher payout. The problem is, when you predict a too strong movement, you will lose your trade and get no payout at all.

Momentum indicators such as the ATR are the ideal tool to predict how a strong a movement you should predict.

Assume for example, that your strategy predicts an upwards movement for an asset that is trading at £100. If the ATR reads 0.2 for a one-hour chart, and your broker offers you a ladder option with a target price of £100.10 and a payout of 150 percent, you know that there is a good chance that you will win the option. If you correctly predicted an upwards movement, you will likely win your option. Since the payout is twice as high as with a high/low option, most traders would take the chance. If the ATR would read only 0.05, you should trade a high/low option.

In this simple way, momentum indicators can help you to increase your average payout without having to change your basic trading strategy. For serious traders, this gift is impossible to pass up.

Volatility Indicators Can Find New Trades

Binary options traders can also use volatility indicators to create trading signals. When the market is moving towards a Bollinger Band, for example, you know that it will likely turn around. This is a prediction that you can trade.

Similarly, when the market has broken through the middle Bollinger Band, you know that it is likely to continue its movement until it reaches the outer Bollinger Band. This knowledge provides a clear indication for how far the market will move, which is a prediction you can trade, too.

Other technical indicators allow for similar predictions.

Three Strategies For Volatility Indicators

We have already touched on three ways in which you can trade volatility indicators. Now we have to define concrete strategies that you can trade. Let’s take a closer look at how you can trade binary options with volatility indicators.

Strategy 1: Combining Bollinger Bands With The ATR

This strategy is so interesting for this article because it combines the advantages of the two momentum indicators on which we have focused. Those advantages are:

  1. Bollinger Bands can predict how far the market will move,
  2. The ATR can predict how long it will take the market to get there.

Combined, both indicators provide you with enough information to trade a binary option with a high payout.

When the market has broken through the middle Bollinger Band, it will likely move to the outer Bollinger Band. This prediction alone is enough to trade a high/low option.

  • When the market has broken through the middle Bollinger Band in an upwards direction, you invest in a high option.
  • When the market has broken through the middle Bollinger Band in a downwards direction, you invest in a low option.

This strategy can make you money – but it limits your payouts to high/low options. The ATR can help you to make more money with the same strategy. All you have to do is compare the ATR’s value to the distance of the next Bollinger Band.

Trade Example

Let’s look at an example. Assume you are looking at an hourly chart and that the next Bollinger Band is £0.1 away. The ATR has a value of 0.025. With this knowledge, you could predict that a perfectly straight movement will take the market to the next Bollinger Band in about 4 hours.

There is only one problem: nobody can guarantee you that all periods will point in the same direction. When only one period points in the opposite direction, it will already take longer for the market to reach the Bollinger Band.

To check your prediction, you can switch to a chart with a period of 4 hours. In our example, let’s assume that the ATR reads 0.075 in this chart. That means an average 4-hour period would be insufficient to take the market to next Bollinger Band. You should expect it to take a little more time, probably around five to six hours.

Volatility Trading

This knowledge helps you to trade a binary option with a higher payout than a high/low option.

  • If you broker offers you a one touch option with a target price in the distance of £0.05 and an expiry of 4 hours, you know that there is a high chance that you will win this option. The movement is within reach of the Bollinger Bands, and the ATR indicates that the market will move the required £0.05 in less than four hours.
  • If your broker offers you a ladder option with a target price £0.05 away from the current market price, the same calculation applies as in our first example.

This strategy is simple and profitable. Bollinger Bands help you to create signals easily, the ATR makes picking the right option type as simple as comparing a few numbers. You know which movements are within reach, and all you have to do is pick the options type with the highest payout to profit from this movement. The entire process is simple and easy – that is the power of momentum indicators.

Strategy 2: Trading The ATR’s Reading With Boundary Options

We have already touched on this strategy. For traders that want to execute it, we will now explain it in full detail. The process is simple and only requires you to compare a few numbers. Here’s what you do:

  1. You create a price chart with the ATR.
  2. You set this price chart to a period of 5 minutes.
  3. Now you compare the ATR’s reading with the boundary option that your broker is offering you for an expiry of five minutes. Two things can happen:
    1. The ATR’s reading is larger than the distance to both target prices. In this case, you invest.
    2. The ATR’s reading is smaller than the distance to both target prices. In this case, you do not invest.
  4. You repeat this process for every expiry that your broker offers you. Match the length of the period of your price chart to the length of the expiry, and if the ATR’s reading is larger than the distance to both target prices, you invest.

This strategy is simple. The only thing you have to figure out is if you want to discount the ATR’s reading. For example, you could require the ATR’s reading to be twice as big as the distance to both target prices of your boundary option before you invest. Try a few discount values, and you will soon find the right strategy for you.

Strategy 3: Trading Ladder Options Based On Bollinger Bands And Prices That Are Out Of Reach

Ladder options can do more than creating high payouts. They can also create very safe trades.

  • When you predict that the market will trade below a target price that is far above the current market price, you are very likely to win this option.
  • When you predict that the market will trade above a target price that is far below the current market price, you are very likely to win this option, too.

This strategy is simple and easy, but there is a catch. Because it creates secure predictions, these predictions get you a very low payout. When you predict that the market will trade below the highest payout when your ladder option expires, you might only get a payout of 10 or 20 percent.

Reduce Risk With Bollinger Bands

Low payouts require you to win a high percentage of your trades to make money. Just a few losing trades might already be enough to lose you money at the end of the week. Therefore, you need a tool that can help you to avoid the rare situation in which you would lose even a safe prediction. Bollinger Bands are the ideal technical indicator for this job.

When a target price lies outside of the outer lines of the Bollinger Bands, the market is highly unlikely to reach it. To check your prediction, you can always invest in the target price with the highest payout that is outside the Bollinger Bands.

Of course, Bollinger Bands change with each new period. To use them for your trading strategy, you have to match the period of your chart to the expiry of your binary option. When you think about trading a ladder option with an expiry of one hour, you have to use a one hour chart and invest right when a new period starts. If 30 minutes have passed in the current period, you have to adjust your chart to leave enough time in the current period for your option to expire. You can use a period of two hours, for example.

Trade Volatility Not Prices

The beauty of this strategy is that it works without predicting the direction of the market. When a price is outside the reach of the upper Bollinger band, you win your option if the market falls. You are also highly likely to win your option if the market falls. The same applies to a price that is outside the reach of the lower Bollinger Band.

To execute this strategy, you only have to follow these three steps:

  1. Set the period of your chart to the shortest expiry that your broker offers for ladder option and apply Bollinger bands to the chart.
  2. Compare the target prices to the Bollinger Bands. Invest in the target price with the highest payout that is outside the reach of the Bollinger Bands.
  3. Repeat the process for each expiry that your broker offers.

Further Risk Management

You might also think about adding a margin of safety. You can do this by requiring target prices to be a certain distance beyond the Bollinger limits.

Applied correctly, this strategy can find you tenths of trading opportunities every day. You can check each chart every time it creates a new period. If your broker offers ladder options with an expiry of five minutes, for example, you can check the chart every five minutes. If only 50 percent of these checks provide you with a trading opportunity, you will still find six opportunities every hour.

If your broker also offers ladder options with an expiry of 15, 30, 60, 120, and 240 minutes, you can add these charts to your trading strategy, too. Now, you can find even more trading opportunities.

In this way, this strategy can find you many low-risk trading opportunities even if you trade only two or three hours every day. Your profit per trade will be small, but based on so many trades, you can still make a lot of money.

Conclusion

Volatility indicators and binary options are a great combination. Indicators such as Bollinger Bands and the Average True Range (ATR) help you to predict the range of a movement and the direction in which the market is likely to move.

You can combine both indicators to trade highly profitable binary options types, trade boundary options based on the ATR alone, or use Bollinger Bands to trade ladder options. Alternatively, you can also add either indicator to your strategy to avoid bad trades and achieve a higher payout.

Volatility indicators offer hundreds of possible trading strategies. You can choose the one you like best, but you should at least consider adding volatility indicators to your strategy. Volatility is an important characteristic of every market environment, and you should at least keep an eye on it.

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